Russian economy bracing for sharp slowdown

March 18th 2020 | Multiple countries | Oil and gas

Russia's decision to walk out on OPEC on March 6th in Vienna and reject Saudi Arabia's proposed crude oil production cuts of 1.5m barrels/day (b/d) caught market participants off guard and sent shockwaves across the globe. Saudi Arabia's unexpected hawkish response to scrap oil production limits, seemingly to punish Russia, sent crude oil prices to four-year lows on March 9th. Furthermore, on March 10th Saudi Arabia's state-run oil producer, Saudi Aramco, announced that it would increase oil production from less than 10m b/d to 12.3m b/d starting in April and target Russia's market share. This puts additional pressure on Russia, which does not have spare capacity to boost production substantially over the short run. Still, Russia's move was a calculated risk by Vladimir Putin, the president, and we believe that Russia will be able to withstand lower oil prices for a long time if a compromise with Saudi Arabia is not reached by mid-2020.

Central bank is well placed to respond

In tandem with the collapse of oil prices from about US$50/b on March 6th to about US$35/b on March 9th, the Russian rouble sold off by nearly 10% to Rb75:US$1—its weakest level since February 2016. To help stabilise the currency, the Central Bank of Russia (CBR) announced on March 9th that it would stop selling roubles to buy foreign currency in March, when it had planned US$3bn-worth of purchases. In addition, the CBR may start to turn directly to foreign-currency sales if market conditions deteriorate further. The CBR will also halt its current easing cycle—the bank slashed rates by 175 basis points from July 2019 to February 2020—and may turn to emergency rate rises in an effort to keep real rates in elevated positive territory to reduce further downward pressure on the rouble.

Furthermore, Russian budget assumptions are made in US dollar terms, but public spending is denominated in roubles, which means that when the rouble depreciates, the dollar price of oil necessary to balance the budget declines. The decline in oil prices exceeds that in the rouble, but it will nonetheless help to support the budget over the coming months. Russian policymakers will be able to tolerate some rouble weakness going forward, but not beyond the point that it results in spiking inflationary pressures, as seen during the 2014 rouble sell-off. A relatively hawkish CBR will keep inflationary pressures sufficiently low not to erode consumer confidence and living standards—a key election promise of Mr Putin.

With crude oil prices trading well below US$42/b, which is the break-even price of oil to balance the government budget, the government will also start tapping the US$150bn (9.2% of GDP) sovereign wealth fund to support the budget. The fund was set up in 2017 and is derived from surplus oil and gas revenue. According to Anton Siluanov, the finance minister, the fund could support the state budget with about US$1.7bn per month for the next six to ten years if crude oil prices remain at US$25-30/b. That said, if the fund's liquid assets dip below 5% of GDP, spending from the fund will be limited to 1% of GDP annually.

Not a 2014 repeat, but outlook clouded

Since the collapse of global oil prices and the introduction of Western sanctions in response to Russia's illegal annexation of Crimea in 2014, the Russian government has sacrificed economic growth to improve Russia's resilience to external shocks. Real GDP growth slowed to 0.7%, government spending stagnated and total investment declined by 0.3% on average in 2014‑19. At the same time, Russia's foreign-currency reserves ballooned to US$570bn (35% of GDP) by February 2020 and now exceed external debt levels. The country produces a large current-account surplus and fiscal restraint has resulted in a budget surplus since 2018, while public debt is low at just 12.6% of GDP. In addition, the Russian economy has become less dependent on crude oil for growth. The Ministry of Finance estimates that the oil and gas sector accounts for 35% of government revenue and 53% of exports, compared with 50% and 70%, respectively, prior to the oil price crash in 2014.

Putin's dilemma

Russia's economy has become more resilient, but this does not mean that the government can resort to a countercyclical fiscal stimulus to support growth in 2020‑21. We will revise down our real GDP growth forecast for 2020 from 1.7% to well below 1% and for 2021 from 1.8% to just over 1%, in our next forecasting round.

We believe that Mr Putin's flagship US$400bn National Projects initiative will come under pressure and may be delayed further, after a slow start in 2018‑19, and this would dampen economic activity. Mr Putin further pledged in January to spend about US$60bn on infrastructure and social welfare to lift living standards, amid plunging approval ratings. This additional spending package may also not materialise, which will not go down well among the public and may dent Mr Putin's approval rating further. Nevertheless, the president, a traditional fiscal hawk, is unlikely to resort to running a large budget deficit or running down reserves, which would make Russia more vulnerable to future sanctions.

Low global oil prices, combined with a sharp fall in energy demand from Russia's largest trading partners, the EU and China, as a result of the coronavirus epidemic, will further weaken economic activity. Mineral fuel exports to China in 2019 were worth more than US$41bn and those to the EU more than US$110bn, equivalent to more than 9% of GDP. Therefore, oil prices set to be nearly 42% lower in 2020 on average compared with 2019, in combination with weaker energy demand from both trading partners, will knock off up to 1 percentage point from real GDP growth in Russia. The current-account surplus will come under pressure amid the poor outlook for the energy sector, reducing foreign-currency inflows. In addition, although the fiscal balance will also probably turn negative in the second and third quarter, in an effort to safeguard reserves and keep the public debt at current low levels, the government will curb spending, hurting both government and household consumption growth. This fiscal restraint will shave up to an additional 0.5 percentage points off economic growth this year.